Inspiration from physics for thinking about economics, finance and social systems

Sunday, February 10, 2013

Let there be light

*** UPDATE BELOW***

My Bloomberg column this month looks at an idea for improving the
function of the interbank lending market. The idea is radical, yet also
conceptually very simple. It's radical because it proposes a complete
transformation of banking transparency. It shows how transparency may be
the best route to achieving overall banking stability and efficiency.
It will be interesting to see what free-market ideologues think of the
idea, as it doesn't fit into any standard ideological narrative such as "get government out of the way" or "unregulated markets work best." It offers a
means to improve market function -- something one would expect
free-market cheerleaders to favor -- but does so in a way that threatens
banking secrecy and also involves some central coordination.

My column was necessarily vague on detail given its length, so let me give some more discussion here. The paper presenting the ideas is this one by Stefan
Thurner and Sebastian Poledna. It is first important to recognize that
they consider here not all markets, but specifically the interbank
market, in which banks loan funds to one another to manage demands for
liquidity. This is the market that famously froze up following the
collapse of Lehman Brothers, as banks suddenly realized they had no
understanding at all of the risks facing potential counterparties. The
solution proposed by Thurner and Poledna strikes directly at such
uncertainty, by offering a mechanism to calculate those risks and make
them available to everyone.

Here's the basic logic of their argument. They start with the point that
standard theories of finance operate on the basis of wholly unrealistic
assumptions about the ability of financial
institutions to assess their risks rationally. Even if the individuals at these institutions were
rational, the overwhelming complexity of today's market makes it
impossible to judge systemic risks because of a lack of information:

Since the beginning of banking the possibility of a lender to assess the
riskiness of a potential borrower has been essential. In a rational
world, the result of this assessment determines the terms of a lender-borrower relationship
(risk-premium), including the possibility that no deal would be
established in case the borrower appears to be too risky. When a
potential borrower is a node in a lending-borrowing network, the node’s
riskiness (or creditworthiness) not only depends on its financial
conditions, but also on those who have lending-borrowing relations with
that node. The riskiness of these neighboring nodes depends on the
conditions of their neighbors, and so on. In this way the concept of
risk loses its local character between a borrower and a lender, and
becomes systemic.

The assessment of the riskiness of a node turns into an assessment of
the entire financial network [1]. Such an exercise can only carried out
with information on the asset-liablilty network. This information is, up to now, not available
to individual nodes in that network. In this sense, financial networks –
the interbank market in particular – are opaque. This intransparency makes it impossible for
individual banks to make rational decisions on lending terms in a
financial network, which leads to a fundamental principle: Opacity in
financial networks rules out the possibility of rational risk
assessment, and consequently, transparency, i.e. access to system-wide
information is a necessary condition for any systemic risk management.

In this connection, recall Alan Greenspan's famous admission that he had trusted in the
ability of rational bankers to keep markets working by controlling their
counterparty risk. As he exclaimed in 2006,

"Those of us who have looked to the self-interest
of lending institutions to protect shareholder's equity -- myself
especially -- are in a state of shocked disbelief."

The trouble, at least partially, is that no matter how self-interested those lending institutions were, they couldn't possibly have made the staggeringly complex calculations required to assess those risks accurately. The system is too complex. They lacked necessary information. Hence, as Thurner and Poledna point
out, we might help things by making this information more transparent.

The
question then becomes: is it possible to do this? Well, here's one idea. As the authors point out, much of the information that would be required
to compute the systemic risks associated with any one bank is already
reported to central banks, at least in developed nations. No private
party has this information. No single investment bank has this
information. Perhaps even no single central bank has this information.
But central banks together do have it, and they could use it to perform a
calculation of considerably value (again, in the context of the
interbank market):

In most developed countries interbank loans are recorded in the ‘central
credit register’ of Central Banks, that reflects the asset-liability
network of a country [5]. The capital structure of banks is available through standard reporting
to Central Banks. Payment systems record financial flows with a time
resolution of one second, see e.g. [6]. Several studies have been carried out on historical
data of asset-liability networks [7–12], including overnight markets
[13], and financial flows [14].

Given this data, it is possible (for Central Banks) to compute network
metrics of the asset-liability matrix in real-time, which in combination
with the capital structure of banks, allows to define a systemic
risk-rating of banks. A systemically risky bank in the following is a
bank that – should it default – will have a substantial impact (losses
due to failed credits) on other nodes in the network. The idea of
network metrics is to systematically capture the fact, that by borrowing
from a systemically risky bank, the borrower also becomes systemically more risky since its
default might tip the lender into default. These metrics are inspired by
PageRank, where a webpage, that is linked to a famous page, gets a
share of the ‘fame’. A metric similar to PageRank, the so-called
DebtRank, has been recently used to capture systemic risk levels in
financial networks [15].

I wrote a little about this DebtRank idea here. It's a computational
algorithm applied to a financial network which offers a means to assess
systemic risks in a coherent, self-consistent way; it brings network
effects into view. The technical details aren't so important, but the
original paper proposing the notion is here. The important thing
is that the DebtRank algorithm, along with the data provided to central
banks, makes it possible in principle to calculate a good estimate of
the overall systemic risk presented by any bank in the network.

So imagine this: central banks around the world get together tomorrow,
and within a month or so manage to coordinate their information flows (ok, maybe that's optimistic).
They set up some computers to run the calculations, and a server to host
the results, which would be updated every day, perhaps even hourly. Soon you or I or any banker in the
world could go to some web site and in a few seconds read out the DebtRank
score for any bank in the developed world, and also to see the listing
of banks ranked by the systemic risks they present. Wouldn't that be
wonderful? Even if central banks took no further steps, this alone would
be a valuable project, using global information to produce a globally
valuable information resource for everyone. (Notice also that publishing
DebtRank scores isn't the same as publishing all the data that banks
supply to their central banks. That level of detail could be kept
secret, with only the single measure of overall systemic risk being
published.)

I would hope that almost everyone would be in favor of such a
project or something like it. Of course, one group would be dead set
against it -- those banks who have the highest DebtRank scores because
they are systemically the most risky. But their private concerns
shouldn't trump the public interest in reducing such risks. Measuring
and making such numbers public is the first step in making any such
reduction.

But Thurner and Poledna do go further in making a specific proposal for
using this information in a sensible way to reduce systemic risks.
Here's how that works. Banks in the interbank market borrow funds for
varying amounts of time from other banks. Typically, there's a standard
interbank interest rate prevailing for all banks (as far as I
understand). Hence, a bank looking to borrow doesn't really have much
preference as to which bank it finds as a lender; the interest paid will be
the same. But if the choice of lender doesn't matter to the borrowing
bank, it does matter a lot to the rest of us, as borrowing from a
systemically risky bank threatens the financial system. If the borrower
can't pay back, that risky bank could be put into distress and cause
trouble for the system at large. So, we really should have banks in the
interbank market looking to borrow first from the least systemically
risky banks, i.e. from those with low values of DebtRank.

This is what Thurner and Poledna propose. Let central banks regulate
that borrowers in the interbank market do just that -- seek out the
least risky banks first as lenders. In this way, banks acting to take on
lots of systemic risk would thereby be marked as too dangerous to make
further loans. Further borrowing would instead be undertaken by less
risky banks, thereby improving the spread of risks across the system.
Don't trust in the miracle of the free market to make this happen -- it won't -- but step in and provide a mechanism for it to happen. As the authors describe it:

The idea is to reduce systemic risk in the IB network by not allowing
borrowers to borrow from risky nodes. In this way systemically risky
nodes are punished, and an incentive for nodes is established to be low in
systemic riskiness. Note, that lending to a systemically dangerous node
does not increase the systemic riskiness of the lender. We implement this scheme by making the
DebtRank of all banks visible to those banks that want to borrow. The
borrower sees the DebtRank of all its potential lenders, and is required
(that is the regulation part) to ask the lenders for IB loans in the
order of their inverse DebtRank. In other words, it has to ask the least
risky bank first, then the second risky one, etc. In this way the most
risky banks are refrained from (profitable) lending opportunities, until
they reduce their liabilities over time, which makes them less risky.
Only then will they find lending possibilities again. This mechanism has
the effect of distributing risk homogeneously through the network.

The overall effect in the interbank market would be -- in an idealized
model, at least -- to make systemic banking collapses much less likely.
Thurner and Poledna ran a number of agent-based simulations to test out
the dynamics of such a market, with encouraging results. The model
involves banks, firms and households and their interactions; details in
the paper for those interested. Bottom line, as illustrated in the
figure below, is that cascading defaults through the banking system
become much less likely. Here the red shows the statistical likelihood
over many runs of banking cascades of varying size (number of banks
involved) when borrowing banks choose their counterparties at random;
this is the "business as usual" situation, akin to the market today. In
contrast, the green and blue show the same distribution if borrowers
instead sought counterparties so as to avoid those with high values of DebtRank (green
and blue for slightly different conditions). Clearly, system wide
problems become much less likely.

Another way to put it is this: banks currently have no incentive whatsoever, when seeking to borrow, to avoid borrowing from banks that play systemically important roles in the financial system. They don't care who they borrow from. But we do care, and we could easily force them -- using information that is already collected -- to borrow in a more responsible, safer way. Can there be any argument against that?

What are the chances for such a sensible idea to be put into practice? I
have no idea. But I certainly hope these ideas make it quickly onto the
radar of people at the new Office for Financial Research.

**UPDATE**
A reader emailed to alert me to this blog he runs which champions the idea of "ultra transparency" as a means for ensuring greater stability in finance. At face value, it makes a lot of sense and I think that the work I wrote about today fits into this perspective very well. The idea is simply that governments can provide information resources to the markets which would support better decisions by everyone in reckoning risks and rewards. Of course, we need independent people and firms gathering information in a decentralized way. But that isn't enough. In today's hypercomplex markets, some of the risks are simply invisible to anyone lacking vast quantities of data and the means to analyze them. Only governments currently have the requisite access to such information.

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This blogexplores the potential for the transformation of economics and finance through the inspiration of physics and the other natural sciences. If traditional economics has emphasized self-regulation and market equilibrium, the new perspective emphasizes the myriad positive feed backs that often drive markets away from equilibrium and cause tumultuous crashes and other crises. Read more about the idea.

Who am I?

Physicist and science writer. I was formerly an editor with the international science journal Nature and also the magazine New Scientist. I am the author of three earlier books, and have written extensively for publications including Nature, Science, the New York Times, Wired and the Harvard Business Review. I currently write monthly columns for Nature Physics and for Bloomberg Views.